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INVESTMENT APPRAISAL - Coggle Diagram
INVESTMENT APPRAISAL
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average rate of return (ARR): measures the annual profitability of an investment as a percentage of the initial investment
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criterion rate or level: the minimum level (maximum for payback period) set by management for investment appraisal results for a project to be accepted
Advantages
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• It focuses on profitability, which is the central objective of
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Disadvantages
• It ignores the timing of the cash flows. This could result in two projects having similar ARR results, but one could pay back much more quickly than the other.
• As all cash inflows are included, the later cash flows, which are less likely to be accurate, are incorporated into the calculation.
• The time value of money is ignored as the cash flows have not been discounted – this concept is considered in the section on net present value.
payback period: length of time it takes for the net cash inflows to pay back the original capital cost of the investment
(additional cash inflow needed / annual cash flow in year 3) x 12 months
Advantages
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gives the benefit of concentrating on the more accurate short-term forecasts of the project’s profitability.
• The result can be used to eliminate or ‘screen out’ projects that give returns too far into the future.
• It is particularly useful for businesses where liquidity is of greater significance than overall profitability.
Disadvantages
It does not measure the overall profitability of a project – indeed,
it ignores all of the cash flows after the payback period. It may be possible for an investment to give a really rapid return of capital but then to offer no other cash inflows.
• This concentration on the short term may lead businesses to reject very profitable investments just because they take some time to repay the capital.
• It does not consider the timing of the cash flows during the payback period – this will become clearer when the principle of discounting is examined in the other two appraisal methods (average rate of return and net present value).
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